Europe aerospace frets over U.S. contracts

AudeLagorce

PARIS (MarketWatch) -- A legislative threat from the U.S. may put European firms in jeopardy of losing access to the most lucrative defense budget in the world -- the Pentagon's.

If the Senate clears a piece of legislation put forward by the House of Representatives, it would prevent foreign companies that benefit from government aid from bidding for U.S. contracts - and would effectively prevent EADS and BAE Systems from pursuing American work.

"Even though the U.S. budget is expected to plateau in the next few years, it's still where you want to be," said Gareth Evans, with AT Kearney's aerospace and defense practice.

EADS (TICKER:FR:005730) and BAE Systems, which respectively own 80% and 20% of Airbus, would be prevented from seeking U.S. contracts if the legislation were passed.

The legislation is designed to affect not just the biggest defense companies, the prime contractors as they're known, but also smaller players further down the industry's food chain as well joint-venture partners.

"I don't think for a second that the Senate will approve it," said Doug McVitie of consultancy Arran Aerospace.

The bill was resurrected to keep EADS out of a lucrative Boeing tanker refueling contract. Now that EADS has announced it will partner with Northrop Grumman
NOC, +0.30%
to bid on the contract, the legislation is likely to be dropped.

The U.S. budget is all the more important with no near-term prospects for a unified European defense budget, especially after the recent rejections of the European constitution in France and the Netherlands.

As a result, European aerospace firms are likely to step up their offensive for coveted Pentagon spending.

"The lack of a unified defense budget is certainly a problem," said Alex Dorrian, chief executive of Thales U.K., the division of Thales SA, and executive vice president for international operations at the Paris Air Show. "If we can find a way to cooperate more in research and development, then it's for the greater good of the industry."

The U.S. defense market is the largest in the world, with a budget of around $400 billion that's projected to grow to around $500 billion in the next five years. It dwarfs that of Europe, which reached $38.4 billion in the U.K. in 2004, $29.5 billion in France and $24 billion in Germany.

Different methods

Different European countries go about chasing Pentagon contracts in various ways.

The British, especially BAE Systems PLC (TICKER:BAE)(TICKER:UK:BA) , like to go out and acquire profitable American defense contractors. BAE spent $800 million in 2004 to buy five U.S. defense companies, the largest of which was DigitalNet, an IT group, for $616 million

In March, BAE's North America division announced its latest purchase: the more than $4 billion acquisition of United Defense Industries (TICKER:UDI)

"It gives them market access and more scale, which usually helps boost the share price," said Evans.

The strategy, however, has a major drawback: it doesn't allow the European owner to repatriate technology. "It gets to the point where a European company that owns a U.S. firm won't be allowed to sit in on some tech meetings"" said Evans.

Thales' Dorrian agrees that buying U.S. companies can be tricky. The move doesn't allow the buyer to justify synergies based on the repatriation of technology to Europe. In addition, the acquired company must stay in the U.S., employ a mainly U.S. management team and generally maintain its U.S.-centric identity.

Partly for those reasons, European companies generally prefer the joint-venture option. French engine maker Snecma SA, a unit of Safran (TICKER:FR:532874), works with

Anglo-Italian company AgustaWestland, owned by Finmeccanica SpA (TICKER:IT:140784), partnered with Lockheed Martin Corp. (TICKER:LMT) and Bell Helicopter and went on to win the contract for a new fleet of "Marine One" helicopters for the U.S. president.

Thales regularly works with U.S. firms like Northrop Grumman and Boeing to bid for contracts. "You can't be credible in the U.S. unless you have a partnership with a big U.S. firm," Dorrian said.

Only last week, on the eve of the Paris Air Show, European defense giant EADS confirmed that theory by teaming up with Northrop Grumman Corp. in a bid to break Boeing's monopoly on supplying aerial-refueling planes to the U.S. military.

Asia alternative?

In the face of this potential tightening of rules across the Atlantic, European contractors are increasingly turning to Asia as an alternative market.

Indeed, the battle for market share will heat up in Asia, consultancy AT Kearney said in a recent study on the aerospace and defense industry.

The potential of the Asian market is in evidence here at the air show in Le Bourget, signaled by the larger exhibition areas the region occupies this year. Asia's demographic boom means its transportation needs will skyrocket in the next few years. China, for example, is expected to order 1,000 planes over the next decade.

Of the nine aircraft orders that J.P. Morgan believes may be placed at the Paris Air Show, five will likely be from Asian carriers and three from the Middle East. These two regions already represent 40% of Boeing's and Airbus' backlog, despite comprising only 20% of all aircraft in service.

On the defense side, however, the situation is trickier. The weapon arms embargo imposed by the European Union upon on China, in particular, is something European companies would be eager to see lifted.

"They can't unilaterally decide to lift the embargo. The geopolitical consequences of such a decision must also be carefully thought through," said Eric Bernardini, with the aerospace and defense practice of AT Kearney.

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